Currency Risk - Electronic trading

Looking for a central system

The range of electronic trading platforms for the foreign exchange markets is expanding quickly, allowing greater access for more market participants. But some fear that the development of multiple systems could split liquidity in the market. Alan McNee reports

A wealth of foreign exchange electronic trading and matching platforms could eventually allow end-users and smaller financial institutions the same level of access to liquidity as the major foreign exchange banks.

A new generation of Web-based products is trying to give electronic access to a wider range of participants, including corporate treasury departments, hedge funds, independent foreign exchange traders and even retail investors.

The traditional electronic platform offered by Reuters since 1989 has already faced its first serious challenge from the Electronic Broking Service (EBS) Partnership. Reuters is fighting back with the launch of its upgraded Dealing 3000 screen-based system. But both EBS and Reuters give access to a relatively limited number of players, focusing on the interbank market.

However, the new developments also raise an important question: do multiple matching and trading systems fragment liquidity in the market?

Other issues facing the market include the competition between banks to give direct access to their clients through the Web, and the development of a system to link services offered by a variety of banks. The latter is widely predicted, but it remains to be seen which company will actually develop the system. There are a number of potential candidates, among system vendors and the banks themselves.

Reuters and EBS compete head-on for the liquidity offered by major foreign exchange banks. EBS was set up in 1990 to challenge the monopoly that Reuters’ electronic system enjoyed. Backed by a group of 13 banks, including Citibank, Chase Manhattan, Credit Suisse First Boston, JP Morgan and UBS, the partnership offers electronic interbank broking for eight currencies. It has around 800 participating banks and average daily volumes of $80 billion.

But foreign exchange trading volumes were hit hard last year. Factors contributing to the decline were Y2K fears, mergers and consolidation in the banking industry and the launch of the euro, as well as generally low volatility in major currencies.

“Mergers took whole dealing rooms out of the market, permanently removing liquidity,” says EBS chairman Peter Bartko, “while consolidation saw some banks concentrate their forex business on large regional centres in London, Singapore or New York, at the expense of local branches.”

EBS also failed to establish much liquidity in sterling, although Bartko says a promotional push beginning this month will aim to attract more sterling liquidity to the EBS screens.

Reuters, whose Dealing 2000 products were virtually unchallenged in the foreign exchange interbank market until EBS was formed, last month announced the launch of its upgraded Dealing 3000 system. The new product was formed partly in response to competition from EBS and elsewhere, says Marion King, Reuters’ managing director for money transaction systems, and partly in response to customer demand.

The previous system comprised Dealing 2000-1, a “conversational” service, which Reuters claims is used for around half the world’s foreign exchange trading, and Dealing 2000-2, an anonymous electronic price matching service. Under the new system, these will correspond to Dealing 3000 Direct (the conversational system) and Dealing 3000 spot matching.

King says Dealing 3000 is changing over from the old proprietary front-end used on Dealing 2000 to a Windows NT environment, with an improved look and flexible screen layout. Its other new features include a broadcast facility, the ability to carry out more conversations and access to Reuters’ core financial information packages, the Reuters Integrated Data Network (IDN).

However, the new Reuters system still requires a separate terminal to trade, rather than allowing access through a trader’s PC, and is not Web-capable. The interbank market will undoubtedly continue to use Reuters – over 160 clients have already signed up for Dealing 3000, and firms including Citibank, UBS and Deutsche Bank have been involved in beta-testing the system. But the real cutting-edge developments are coming from smaller, more agile organisations, using Internet technology to try to transform the way foreign exchange is traded.

Among these new systems are Irish e-commerce firm Cognotec, Seattle-based Financial Market Solutions (FMS), and New York’s MatchbookFX. Cognotec provides a “blind” system, where anyone with an appropriate credit rating can deal at a certain price. Cognotec’s Web-based AutoDeal Lite software generates prices for corporate and retail customers, taking their credit rating into account. Its latest offering, Liquidity Linq, is part of AutoDeal Lite and aims to provide connections between major foreign exchange banks – the liquidity providers to the market – and smaller local or regional banks, which service niche markets or specific customer franchises.

Direct action
MatchbookFX is described as a self-dealing trading network. In other words “the traders participate directly in the price action,” according to Joshua Levy, executive director. Levy claims other networks act as market makers, adjusting the price on request.

With MatchbookFX’s system, the potential customer sees the price available before making a decision to trade. It is an anonymous system, based on a proprietary dealing platform. Customers deal with MatchbookFX itself rather than with each other, avoiding any counterparty credit issues. All accounts are collateralised and margined, so that every order is guaranteed to be backed by sufficient funds, although Levy denies this means the firm is operating as a virtual exchange. “We don’t view ourselves as an exchange, but as an on-line FX dealing operation,” he insists.

While some market participants worry that a burgeoning number of electronic networks could split liquidity in the foreign exchange market, Levy says MatchbookFX has a number of market makers that also trade on systems such as EBS, so “the system acts as a conduit to the wide swathe of the global spot forex market”.

FMS makes a similar argument. It follows the principle that Internet technology will allow foreign exchange markets to develop along the same lines as US equity markets, with a massive growth in retail investor interest. “The idea is to allow people to access the market directly,” says FMS president Scott Wilson. “Our idea is that the forex market is currently suffering from fragmentation of liquidity, and we believe we can bring liquidity together in one central pool.”

Eyup Saltik, co-chief executive officer of FMS, says the aim is “to increase liquidity both horizontally and vertically”. Boosting “vertical” liquidity involves bringing retail investors, hedge fund managers, independent traders and others together in the market as clients, while maintaining different levels of access to banks for counterparty credit reasons. “Horizontal” liquidity means that banks can use the system not only to deal with this pool of clients, but also to connect with other banks. This is a similar concept to Cognotec’s Liquidity Linq. If successful, such a system would provide banks and their clients with access to one massive pool of liquidity on the same platform.

Saltik believes new technology will bring about the same revolution in foreign exchange markets as has occurred in equities. “We envisage a move towards 100% Web-based forex trade, plus a shift towards ‘perfect market’ conditions, in which the margins charged per trade will be lower, but the banks will be compensated by much higher volumes,” he predicts. FMS aims to go live with its system in the first half of this year.

But doubts remain as to whether enough banks will sign up for one particular system to make it effective in this way.

Most of the big foreign exchange banks already have or are developing Web-based systems of their own to trade with clients. Citibank, for example, is bringing together its two current electronic execution products under the name Chief Dealer. This will allow customers to trade on a benchmark price, which is fixed at set intervals throughout the day, or on its FX Link system, which provides an interactive price based on live rates. The prices are generated by Citibank’s own internal pricing engine, which covers 85 currencies in spot, forward and swaps trades.

Other banks such as NatWest Global Financial Markets and Warburg Dillon Read have similar Web-based systems of their own, often offering analysis and research as well as electronic trade execution.

But most bankers concede that the next stage will be a system that connects not only clients and banks, but banks and other banks. The system that achieves enough critical mass to become indispensable could quickly turn into the industry standard, sidelining other competing systems.

© Financial Engineering Ltd, 2000             This download is provided for personal use only and not for redistribution.